Thursday, June 21, 2012

Drachmatic Monetary Policy

The trauma of drachmatazation and how monetary policy could be conducted

A recent blog post from Evan mentioned some of the problems in drachmazation, and as my list of thoughts steadily grew longer, I thought I would explicate them more fully in a blog post.

In his post, Evan mentioned that:

To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive  -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma. 

I find this to be an interesting point, but I think his arguments about the legal status of the Euro are a bit more important. Without a legal mandate that the Euro can't be used in the future, there would truly be no incentive for people to go exchange their euros in the transition. If the conversion rate did not offer enough drachmas for every Euro, then not enough people would go. If too many drachmas were offered, then there would be additional inflationary pressures. Moreover, if the borders controlling capital inflow were porous, foreigners could go in and exchange their euros for drachma at the favorable rate. However, if capital controls are tight enough and the legal mandate for the use of the Euro certain, then domestic Greeks would have an incentive to exchange Euro for drachma, while foreigners would have no incentive to do so.

Evan concludes his post on possibilities for the future of Greek monetary policy. As a market monetarist is wont to do, he floats the idea of an NGDP target to limit the inflation expectations when the Greek government becomes dependent on the central bank for financing. While it sounds good in theory, this is an important example of where NGDP targeting fails in stabilizing crises. If the Greek government is going to be in such bad shape after the exit, what guarantee do we have that any of the data will be reliable? If it's not even certain who's withdrawing money and what currencies are being spent, how does one measure the net value of all the transactions to get an NGDP number? Given the turmoil, it's also unlikely that a deep NGDP futures market would be established, so there would be no way to evaluate whether NGDP is on trend or not. Once it becomes logistically impossible to maintain a credible NGDP targeting, all of the expectations-based arguments used to support NGDP level targeting start to buckle. If the public suspects that the central bank may overshoot, they can go with the momentum and send NGDP off its trend. The same would be true if there were expectations that NGDP was falling and the central bank wouldn't respond quickly enough. Although, in the end, the level target would function, the lack of true credibility would make for wild short term gyrations. In this situation, a composite inflation and rate change of employment target might function better, as quick statistical surveys could get a snapshot of these statistics. This data consideration is a very important point once NGDP targeting starts to spread to other countries. If financial markets aren't deep enough for NGDP futures targeting, and quarterly NGDP statistics are hard to verify, it may be better to work with what we have with regards to inflation and unemployment data.

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